Macroeconomics
Eighth Edition, Global Edition
Chapter 4
Financial Markets Ⅰ
•
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Chapter 4 Outline
Financial Markets I
4.1 The Demand for Money
4.2 Determining the Interest Rate: Ⅰ
4.3 Determining the Interest Rate: Ⅱ
4.4 The Liquidity Trap
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Financial Markets
• Financial markets are intimidating, but they play an
essential role in the economy.
• In this chapter, we focus on the role of the central bank in
affecting these interest rates.
• We learn how the interest rate on bonds is determined,
and the role of the central bank (Federal Reserve Bank,
or the Fed, in the United States) in this determination.
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4-1 The Demand for Money
• Suppose you only have a choice between two assets:
money and bonds.
• Money are used for transactions, but it pays no interest.
• Two types of money: currency and checkable deposits.
• Bonds pay a positive interest rate, i (the rate of interest),
but cannot be used for transaction.
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4-1 The Demand for Money
• The holding of money and bonds depends on:
– Your level of transactions $Y
– The interest rate on bonds i
• You can hold bonds indirectly through money market
funds, or money market mutual funds.
• In the early 1980s, the interest rate on money market funds
reached 14% per year, so people earned more interest by
moving their wealth from checking accounts to these funds.
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Money market mutual fund
• Open end mutual fund vs. Closed end
• An open end mutual fund (tradition): A type of mutual fund that
does not have restrictions on the amount of shares the fund will
issue. If demand is high enough, the fund will continue to issue
shares no matter how many investors there are. Open-end
funds also buy back shares when investors wish to sell.
• A closed-end fund (new), CEF, is a publicly traded investment
company that raises a fixed amount of capital through an initial
public offering (IPO). The fund is then structured, listed and
traded like a stock on a stock exchange.
• Money market mutual funds are open-end mutual funds
• ETF (not CEF) : exchange-traded funds (daily trade)
https://www.fidelity.com/learning-center/investmentproducts/closed-end-funds/cefs-mutual-funds-etfs
•
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FOCUS: Semantic Traps: Money, Income, and
Wealth
• Money is what can be used to pay for transactions.
• Income is what you earn, and it is a flow.
• Saving is the part of after-tax income that you do not spend, and
it is also a flow.
• Savings is the value of what you have accumulated over time.
Stock variable
• Financial wealth, or wealth, is the value of all your financial
assets minus all your financial liabilities, and it is a stock variable
• Investment is what economists refer to as the purchase of new
capital goods.
• Financial investment is the purchase of shares or other financial
assets.
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4-1 The Demand for Money
• Demand for money (Md) is equal to nominal income $Y (a
measure of level of transactions in the economy) times a
decreasing function of the interest rate i:
What is the interest rate?
Functions of money
Medium of exchange
Unit of account
Store of value
• Money is the most liquid asset in the world
• An increase in the interest rate decreases the demand for
money, as people put more of their wealth into bonds.
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4.1 The Demand for Money (4 of 5)
• Equation (4.1) means that the demand for money:
– increases in proportion to nominal income, and
– depends negatively on the interest rate.
• The relation between the demand for money and interest
rate for a given level of income $Y is represented by the
Md curve.
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4-1 The Demand for Money
Figure 4-1 The Demand for Money
For a given level of
nominal income, a
lower interest rate
increases the
demand for money.
At a given interest
rate, an increase in
nominal income
shifts the demand for
money to the right.
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FOCUS: Who Holds U.S. Currency
• The amount of currency in circulation in 2006 was $750
billion.
• U.S. households together held $170 billion in currency.
• U.S. firms held another $80 billion.
• Foreigners abroad held $500 billion, or 66% of the total, for
transactions, especially in countries suffering from high
inflation in the past.
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4-2 Determining the Interest Rate: I
• Suppose the central bank decides to supply an amount of
money equal to M:
Ms = M
• Equilibrium in financial markets requires that Ms=Md=M
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4-2 Determining the Interest Rate: I
Figure 4-2 The Determination of the Interest Rate
The interest rate
must be such that
the supply of
money (which is
independent of the
interest rate) is
equal to the
demand for money
(which does
depend on the
interest rate).
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4-2 Determining the Interest Rate: I
Figure 4-3 The Effects of an Increase in Nominal Income on
the Interest Rate
Given the money
supply, an
increase in
nominal income
leads to an
increase in the
interest rate.
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4-2 Determining the Interest Rate: I
Figure 4-4 The Effects of an Increase in the Money Supply
on the Interest Rate
An increase in the
supply of money
leads to a decrease
in the interest rate.
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4.2 Determining the Interest Rate: Ⅰ (5 of 9)
• For a given money supply, an increase in nominal income
leads to an increase in the interest rate.
• An increase in the supply of money by the central bank
leads to a decrease in the interest rate.
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4-2 Determining the Interest Rate: I
• Central banks typically change the supply of money by
buying or selling bonds in the bond market—open market
operations.
• Expansionary open market operation: the central bank
expands the supply of money by buying bonds.
• Contractionary open market operation: the central bank
contracts the supply of money by selling bonds.
– Treasury bills are issued for terms of less than a year.
– Treasury notes are issued for terms of two, three, five, seven, and
10 years.
– Treasury bonds are issued for terms of 30 years.
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4.2 Determining the Interest Rate: Ⅰ (7 of 9)
Figure 4.5 The Balance Sheet of the Central Bank and the
Effects of an Expansionary Open Market Operation
The assets of the central
bank are the bonds it
holds.
The liabilities are the stock
of money in the economy.
An open market operation
in which the central bank
buys bonds and issues
money increases both
assets and liabilities by the
same amount.
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4-2 Determining the Interest Rate: I
• Suppose a bond such as a Treasury bill, or T-bill,
promises to pay $100 a year from now.
• If the price of the bond today is $PB, then the interest rate
on the bond is:
$100 − $𝑃𝐵
𝑖=
$𝑃𝐵
• The higher the price of the bond, the lower the interest rate.
• The higher the interest rate, the lower the price today.
• Discount bonds
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4-2 Determining the Interest Rate: I
Rather than the money supply, the central bank could have
chosen the interest rate and then adjusted the money
supply so as to achieve the interest rate it had chosen.
Choosing the interest rate, instead of the money supply, is
what modern central banks, including the Fed, typically do.
Taylor Rule
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4-3 Determining the Interest Rate: II
• Financial intermediaries: Institutions that receive funds
from people and firms and use these funds to buy financial
assets or to make loans to other people and firms.
• Banks are financial intermediaries that have money, in the
form of checkable deposits, as their liabilities.
• Banks keep as reserves some of the funds they receive.
• The liabilities of the central bank are the money it has
issued, called central bank money.
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4.3 Determining the Interest Rate: Ⅱ (2 of 6)
Figure 4.6 The Balance Sheet of Banks, and the Balance
Sheet of the Central Bank Revisited
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4-3 Determining the Interest Rate: II
Assume people hold no currency so the demand for money
by people is the demand for checkable deposits:
• The demand for reserves by banks depends on the amount
of checkable deposits:
• θ is the reserve ratio, and Hd is demand for high-power
money or the monetary base.
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4-3 Determining the Interest Rate: II
• Let H denote the supply of central bank money, then the
equilibrium condition:
• Or using equation (4.4):
• An increase in H leads to a decrease in the interest rate,
and a decrease in H leads to an increase in the interest
rate.
• monetary base (also base money, money base, highpowered money, reserve money, outside money, central
bank money).
• Outside money is money that is not a liability for anyone
"inside" the economy.
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4-3 Determining the Interest Rate: II
Figure 4-7 Equilibrium in the Market for Central Bank
Money and the Determination of the Interest Rate
The equilibrium interest
rate is such that the
supply of central bank
money is equal to the
demand for central bank
money.
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4.3 Determining the Interest Rate: Ⅱ (6 of 6)
• The federal funds market is an actual market for bank
reserves.
• The federal funds rate is the interest rate determined in
the federal funds market.
• The federal funds rate is the main indicator of U.S.
monetary policy because the Fed can choose the federal
funds rate it wants by changing H.
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FOCUS: Will Bitcoins Replace
Dollars?
• Bitcoins are virtual assets that can be used for
transactions.
• As of December 2018 the total value of bitcoin in
circulation was $67 billion.
• Bitcoins are not likely to replace dollars for 3 reasons:
1. Most transactions are quoted in dollars, so price risk exists.
2. Verifying bitcoin transactions takes too much electricity.
3. Governments do not want bitcoin to be the accepted currency
since they want to control monetary policy.
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4.4 The Liquidity Trap (1 of 2)
• Zero lower bound: The interest rate cannot go below
zero.
• The economy is in a liquidity trap when the interest rate is
down to zero, monetary policy cannot decrease it further.
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4.4 The Liquidity Trap (2 of 2)
Figure 4.8 Money Demand, Money Supply, and the Liquidity
Trap
When the interest rate is equal to
zero, and once people have enough
money for transaction purposes,
they become indifferent between
holding money and holding bonds.
The demand for money becomes
horizontal.
This implies that, when the interest
rate is equal to zero, further
increases in the money supply have
no effect on the interest rate, which
remains equal to zero.
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Tools of Monetary Policy
 Tools of Traditional Monetary Policy
 Open market operation
 Discount rate
 Reserve requirement
 New Monetary policy tools under Ample Reserves Framework
 Interest on Reserves
 Overnight reverse repurchase agreement (ON RRP) rate
https://www.stlouisfed.org/open-vault/2020/august/how-doesfed-influence-interest-rates-using-new-tools
• FFR is higher than IOR
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Before The Crisis
Federal Funds Market
Fed purchases of U.S. government
securities would increase the supply of
reserves in the banking system, thereby
shifting the supply curve to the right and
moving the federal funds rate (FFR) lower.
In contrast, sales of securities would
reduce the supply of reserves, thereby
shifting the supply curve to the left and
moving the FFR higher.
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New Monetary policy Tools under Ample Reserves
Framework
 FFR should be close to IOR
• Banks can deposit it into their reserve account at the Fed
and earn interest on reserves (IOR). Because IOR offers
banks a risk-free option, it serves as a reservation rate —
the lowest rate a lender is willing to accept when lending
funds.
• If IOR>FFR, banks could borrow at the FFR and deposit the
reserves at the Fed (earning the IOR rate) to earn a profit.
• This arbitrage activity should ensure that the FFR won’t fall
very far below the IOR rate and links the rates together.
• Because the IOR rate is an administered rate, the Fed can
nudge the level of the market-determined federal funds rate
by adjusting the setting of interest on reserves. In the ample
reserves framework, IOR is now the primary tool the Fed
uses to adjust the FFR.
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New Monetary policy Tools under Ample Reserves
Framework
 FFR should NOT be lower than ON RRP rate
• Not every financial institution that operates in the federal
funds market has access to interest on reserves. So, the
FFR could fall below the setting of the IOR rate.
• To aid in the control of the level of the FFR, the Fed
introduced the overnight reverse repurchase agreement
(ON RRP) facility to a broad set of financial institutions.
• When an institution uses the ON RRP facility, it essentially
deposits reserves at the Fed overnight, receiving a
government security as collateral. The next day the
transaction is “unwound” — the Fed buys back the security,
and the institution earns the ON RRP rate on the cash it
deposited at the Fed.
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New Monetary policy Tools under Ample Reserves
Framework
 FFR should NOT be lower than ON RRP rate
• Because this (ON RRP rate) is a risk-free investment
option, the institutions will likely never be willing to lend
funds in any market for lower than the ON RRP rate. And, if
similar short-term rates fell too far below the ON RRP rate,
institutions would borrow at those lower rates and deposit
this cash at the ON RRP facility to earn the ON RRP rate.
• These forces link the ON RRP rate to other short-term
rates, including the FFR. Because many large nonbank
financial institutions have access to the Fed’s ON RRP
facility and the ON RRP rate is set below the IOR rate, the
ON RRP rate serves as a supplementary policy tool and
acts like a floor for the FFR.
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After (under Ample
Reserves system)
The Fed no longer uses daily open
market operations to adjust the federal
funds rate.
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FOCUS: The Liquidity Trap in Action
• The large increase in the supply of central bank money between 2008
and 2015 was absorbed by households and banks.
• Uncertainty in economic outlook would cause households to increase
bank deposit and would prompt bank to increase their reserve holdings.
Figure 1 Checkable Deposits and Bank Reserves,
2005−2018 (billions). Source: FRED: TCP, WRESBAL
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Case of USA
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APPENDIX 1: The Determination of the Interest Rate When
People Hold Both Currency and Checkable Deposits
• Assume that overall money demand is:
• Also assume that people hold a fixed proportion of their
money in currency c, and (1−c) in checkable deposits, so the
demand for currency and the demand for checkable deposits
are respectively:
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APPENDIX 1: The Determination of the Interest Rate When
People Hold Both Currency and Checkable Deposits
Figure 4-A1
Determinants of
the Demand and
the Supply of
Central Bank
Money.
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APPENDIX 1: The Determination of the Interest Rate
When People Hold Both Currency and Checkable
Deposits
• Let R be the reserves of banks, D be the dollar amount
checkable deposits, and θ be the reserve ratio:
• Combining (4.A2) and (4.A4) gives the demand for reserves
by banks:
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APPENDIX 1: The Determination of the Interest Rate
When People Hold Both Currency and Checkable
Deposits
• Demand for central bank money is:
so that:
which gives the demand for central bank money:
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APPENDIX 1: The Determination of the Interest Rate When
People Hold Both Currency and Checkable Deposits
• The equilibrium condition is that the supply of central bank
money be equal to the demand for central bank money:
or using equation (4.9):
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APPENDIX 1: The Determination of the Interest Rate When
People Hold Both Currency and Checkable Deposits
• The supply of central bank money (the left side of equation
(4.A9) is equal to the demand for central bank money (the
right side of equation (4.A9), which is equal to the term in
brackets times the overall demand for money.
Fractional Reserve System
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Appendix 2: Monetary base, Money
multiplier
 From eq. (4.A9), we have
1
𝐻 = $𝑌 𝐿(𝑖)
𝑐+ 1−𝑐 𝜃
 The LHS is the total money supply and the RHS is total
money demand.
 The supply of total money is equal to central bank money/high power
money H (or monetary base) times money multiplier (1/[c+(1-c)]).
 Monetary base=currency + reserve
 Money multiplier is greater than one.
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High power money(Monetary Base)
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Money multiplier
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What is the eventual increase in the money supply? The
increase in checkable deposits is $100 when seller 1
deposits the proceeds of his sale of bonds in bank A, plus
$90 when seller 2 deposits the proceeds of her sale of
bonds in bank B, plus $81 when seller 3 does the same, and
so on.
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The series in parentheses is a geometric series so its
sum is equal to
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Definition of money
• 我國中央銀行採用的貨幣定義如下：
M1A = 通貨淨額 + 支票存款 + 活期存款
M1B = M1A + 活期儲蓄存款(個人或非營利法人)
M2 = M1B + 定期存款 + 定期儲蓄存款 + 外匯存款+ 郵政儲
金 + 附買回交易餘額 + 外國人新台幣存款 + 貨幣市場共同基
金
– --準貨幣 (Quasi money)
• 美國：
M1= currency + checkable deposits
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